China puts financial stability ahead of debt control

China’s authorities are increasingly worried by stress in the country’s financial system and the sudden slowdown in economic growth, fearing that it may now be too dangerous to press ahead with their draconian crackdown on shadow banking.

The People’s Bank (PBOC) began signalling late last week that it would soften its assault on the credit markets, shifting to pro-growth and efforts to prevent a liquidity shock before November’s Communist Party Congress.

Premier Li Keqiang has since told the International Monetary Fund that regulatory overkill would be a mistake at this delicate time. The state media says “financial stability” is now a greater priority than debt control.

“They are spooked. They know that shadow banking is running amok but they are not really willing to follow through and take the leverage out of the system,” said George Magnus from the China Centre at Oxford University.

Trouble has been building for weeks. “Certain China macro-indicators that we follow are starting to wave red flags. China’s Monetary Conditions Index (MCI) has seen four consecutive months of declines suggesting liquidity conditions are starting to tighten,” said Jeremy Hale from Citigroup.

China’s credit cycle is an extremely powerful force for the world economy. When it shifts direction, the effects ricochet through the commodity bloc and emerging markets. Secondary waves ultimately reach Europe.

Alarm bell

The “credit impulse” first rolled over in November. The gauge — seen as a leading indicator — has since turned negative. It points to much weaker growth later this year. The PBOC is alarmed by the scale and opaque practices of “wealth management products” and other shadow banking instruments, estimated by Moody’s at $US9.4 trillion or 87 per cent of Chinese GDP. Minsheng Bank has been fined for issuing such products to cover losses on trade credits.

JP Morgan’s Nikolaos Panigirtzoglou said Chinese money market funds, wealth products, and trusts, are intertwined through complex “repo” trades and leveraged cross-holdings — a precarious web that some compare to a giant Ponzi scheme. “The financial interlinkages are reminiscent of the chain-reaction that occurred in the US and Europe following the collapse of structured investment vehicles (SIVs) after the Lehman crisis,” he said. Banks are borrowing on short-term capital markets to lend “long” — like Northern Rock and Lehman Brothers — creating a perilous mismatch of maturities. Huge sums must be refinanced every three months, or sooner.

“This is their Achilles’ Heel. It is very similar to what happened in the West in 2005 to 2006,” said Mr Magnus. “Does this mean it is all going to blow up over the next six months? I don’t think so, but Japan shows you can have a domestic banking crisis even if you have high savings and no foreign debt,” he said.

‘China will not backtrack’

The shift in policy over recent days suggests a Politburo power struggle over how to calibrate a soft-landing. Just a week ago the state mouthpiece Xinhua ran an editorial vowing no let-up in the war on rogue finance. “China is in the midst of its harshest crackdown on financial risks in history. One thing is clear: China will not backtrack,” it said.

There has been a whirlwind of tough rules and fines since Guo Shuqing was appointed chief banking regulator in February. His zeal has turned gentle tightening into a squeeze. Net bond sales by Chinese companies have been negative for the past five months. More than $US17 billion in new issues were cancelled in April.

Five-year borrowing rates have shot up by 150 basis points since November to top 5 per cent. Real rates are rising even faster as factory gate inflation drops back. The long term yield curve has “inverted”, typically a harbinger of recession in Western economies.

The question is whether the new policy language implies a tilt or a complete reversal. Chang Liu from Capital Economics said Beijing will stick to its guns unless there is a sharp slowdown in growth, or a surge in lending costs and bankruptcies. “We think the deceleration in the economy will be gradual,” he said.

Riding a tiger

China’s Caixin manufacturing gauge dropped to a seven-month low in April. The growth of fixed investment in the sector has fallen to zero. Output of cars and mobile phones has stalled as internal demand is squeezed. Iron ore prices have slumped.

The IHS Materials Price Index measuring everything from energy and metals, to lumber, fibres, and freight rates has fallen 11.2 per cent since its February peak, suggesting the world may soon face a fresh wave of imported deflation from China. While oil has rebounded, that is because of output cuts by Opec and Russia.

China’s property market is still hot but curbs are starting to bite. The minimum down-payment for a flat in Beijing and Shanghai is now 60 per cent, and 80 per cent for a second home.

China resorted to extreme credit creation and fiscal spending to avert a crunch 18 months ago. This stimulus began to run out of steam late last year. The latest loan spree has pushed the debt ratio to 260 per cent of GDP. The Chinese Communist Party is riding a tiger. Getting off is becoming almost impossible.